Cryptocurrency stablecoin definition - how does it work?

Bitsgap

·

2019-01-10

In this article, we’ll be talking about stablecoins! These interesting cryptocurrencies are likely the next step in adoption for crypto and they offer a wide variety of benefits. What are they though and how do you use stable assets in your trading strategy? Let’s find out!

What is a stablecoin?

A stablecoin is a cryptocurrency which has a pegged value. This means that the value of that cryptocurrency should not go up and down like normal crypto assets do. In most cases, the peg is to the US dollar, but there are others as well.

Stablecoins can be pegged to nearly anything in theory and there are coins pegged to multiple fiat currencies and even things like gold and silver. What differs for stablecoins is how the peg is maintained, and the entire system is based on trust. That is, trust that the issuer of the coin can maintain the currency’s value.

How do stablecoins work?

The stablecoins are pegged to a particular asset, such as the US dollar. The way they work differs a little depending on the currency, but they all require some type of system which can balance the scales and keep everything in order.

For some centralized stablecoins like Tether, this requires a custodian who issues the currency and then keeps a certain amount of collateral in reserve. Tether keeps US dollars in a bank account, and the amount held must be equal to what they have issued in order to keep order in the system.

However, there are other stable cryptocurrencies like DAI which are decentralized. These stable coins accomplish their goals without a central authority figure. They use smart contracts on the Ethereum blockchain in order to manage the collateral and maintain order.

Examples of stablecoins

Tether - Tether is a centralized stablecoin. It maintains its peg by keeping US dollars in reserve. When new Tether are “printed”, the custodial account must have physical dollars to back up this currency in reserve.

DAI - Dai is a decentralized stable coin. This currency maintains its value by holding Ethereum in collateral. This is managed through smart contracts and if the value of that collateral falls below the safe zone Ethereum is automatically sold in order to maintain the balance.

Why do we need to use stablecoins?

Stablecoins are important for a couple of reasons. The first is that merchants need a stable currency in order for adoption to progress. This allows them to accept crypto for purchases without worrying about the value changing and eroding their small profit margins.

A stable currency is also useful for maintaining value. This allows investors to put their money somewhere safe in times of turbulence and for you to take your chips off the table without actually taking your money out of cryptocurrency entirely.

How does stablecoin make money?

In most cases, the stable coin will require some type of fee to be used. Normally, this fee is paid by whoever takes out the collateral loan. So, if you were to purchase stablecoins from an exchange this would not impact you at all.

What issues are connected to the stablecoins?

Unfortunately, creating a stable coin is easier said than done. Many stable cryptocurrencies like Steemit’s SBD have failed to maintain their peg. This is a big problem, and it keeps some people from trusting stablecoins.

The most reasonable way to have stable asset is to back it with something other than a cryptocurrency because they are highly volatile. However, this creates even bigger problems because those systems are always centralized, which is against the ethos of crypto in the first place.

While DAI has seen some success with their Etheruem based collateral system, it’s still a work in progress. Not enough time has passed for it to prove itself and there are serious problems when using cryptocurrency in this way such as forced liquidations to maintain the peg.

How to get stablecoins?

If you’d like to get yourself some stablecoins, then the easiest way is to just buy them from an exchange. However, this will trigger a taxable event in the eyes of most governments.

For those who are interested in getting access to stable currencies without this, you can instead collateralize some cryptocurrencies like Etheruem to do it. This is essentially a loan and not taxable, and you can still use your crypto to trade or buy things.

In most cases, you’ll only be able to borrow 50-60% of your holdings, and you’ll need to be careful of any price drops. If the value of your collateral drops below a certain amount your position will likely liquidate and you’ll be forced to sell at a loss.

You can keep this from happening by adding more collateral to your position or paying back some of your loan.

Stablecoin regulation

Stablecoins like Tether which are attached to the US dollar have heavy regulation. Since they are backing their cryptocurrency using fiat currency there’s a lot of paperwork to be done to get things rolling. If you want to directly purchase Tether, you’ll need to fill out the appropriate KYC forms.

However, Tether can be traded on exchanges which allow you to trade without registering. This means you can just buy it directly if you’d rather not go through a lengthy verification process.

Decentralized options like DAI function via smart contracts, and you’re not required to go through any regulatory processes to take out DAI loans against your Etheruem.

Stablecoin vs Bitcoin

While Bitcoin’s value can go up or down at any time, a stable coin will always stay the same. This means that you don’t really invest in stablecoins like you do Bitcoin. Instead, you would use a stable coin to keep some of your Bitcoin profits from evaporating if you thought that the market was going to experience some turbulence soon.

This allows you to keep your profits safe without having to exit cryptocurrency markets. It also means that you can trade much faster and you can keep your day trading profits safer overnight so you can actually sleep instead of worrying about it or cashing out to your country’s native fiat currency.